Yellen should take away the punch bowl

Opinion: The Fed should raise margin requirement for borrowing against stocks

The level of margin debt at brokers has reached a record $488 billion.

WASHINGTON (MarketWatch) — The Federal Reserve has a big credibility problem: Everyone believes the Fed will do anything to keep the stock market going up, even if it means blowing bigger and bigger bubbles.

The “Greenspan put” became the “Bernanke put,” and now the “Yellen put.”

The Fed’s quantitative easing programs have only fed the belief that the Fed is the sole source of support for markets. Even after the Fed has begun to taper its QE3 program, there are those who believe it will never stop completely. QE4ever!

New Fed Chairwoman Janet Yellen could restore some of the Fed’s credibility in one bold move: She could create a “Yellen call” by having the Fed increase the margin requirement, thus raising the costs of borrowing to buy stocks and bonds.

The Fed should raise the margin requirement — now at 50% — to 55% or 60% in a symbolic shot across the bow of speculators who think the Fed has their back, who think asset markets are a one-way bet.

There’s no reason to think that nudging the margin requirement would tank the market, but it might take some of the froth out. It might remind investors that stocks — indeed, all assets — are risky.

MarketWatch

The margin requirement for loans from brokers has been stuck at 50% since 1974.

The margin requirement is now 50%, which means that an investor who wants to buy $1 million in stocks and bonds needs to put up only $500,000, and can borrow the rest from the broker. The margin requirement has been stuck at 50% since 1974, because the Fed has refused to use this tool to moderate irrational exuberance and leverage in the stock market.

The Fed wasn’t always so reluctant. The 1929 market boom and bust had been enabled by very low margin requirements. In those days, an investor only needed to put up 10% of the purchase price. The market soared, but what margin gave, it soon took away, in spades.

When the market crashed, many investors were hit by the dreaded margin call, which wiped out their wealth in an instant. Those forced sales to meet margin calls accelerated the crash.

The Fed began to regulate margin accounts. In the 1950s and 1960s, legendary Fed Chairman William McChesney Martin changed the margin requirement frequently to address volatility in the stock market. It was briefly at 100%, which meant that you couldn’t borrow at all against your portfolio. For much of the period, the margin requirement was 70%, which meant you had to put up 70% of the value of the loan.

Martin, of course, was the one who said that the job of the Fed was to take away the punch bowl just before the party got warmed up, which is the opposite of the Fed’s reputation now.

And, in case you think Martin’s puritanical streak was too restrictive, recall that the economy grew at an average rate of 3.8% in the 19 years he was Fed chairman, and the stock market rose 8.1% per year. Since then, GDP has averaged 2.8% and the market has gone up 6.9% on average.

Martin’s successor Alan Greenspan warned that the stock market was in a bubble in 1996, but refused to do anything about it. After that first warning about “irrational exuberance,” he mostly kept quiet about the bubble, even as margin debt and the market peaked in early 2000 before the market lost 40% of its value in an epic crash.

In public, Greenspan insisted that raising the margin requirement would have no impact on stock prices, because most investors had other ways to borrow to fund their investments. But privately, inside the Federal Open Market Committee, he confessed that “if you want to get rid of the bubble [increasing margin requirements] will do it,” adding, “my concern is that I am not sure what else it will do.”

Perhaps Greenspan could afford to be nonchalant about bubbles; he could tell himself that the medicine was worse than the disease. But after the dot-com and housing crashes, we know how much damage a credit-fueled asset bubble can inflict on the real economy.

MarketWatch

Stock valuations are high, but aren't close to the frothy level of 2000.

Yellen is probably right that the stock market isn’t in a bubble right now. Robust profits can justify the high prices. Price-to-earnings ratios, while high, aren’t close to 2000 or even 2007 levels, according to Robert Shiller’s calculations.

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